Treasury and the IRS on December 23 released proposed regulations (the Proposed Regulations) under Sections 863, 865, 937, and 1502. The Proposed Regulations would implement changes to Section 863(b) enacted in the 2017 tax reform act (the Act), and coordinate Section 863(b) with certain other rules for determining the source of income derived by non-US residents under Section 865.
The Act changed the source-of-income rules applicable to the sale of inventory manufactured by the taxpayer to be based solely on the location of manufacture. Before the Act, income from the sale of manufactured inventory was sourced by reference to both manufacturing and sales activities.
In light of the statutory change to Section 863(b), the Proposed Regulations under Section 863(b) eliminate the historic three methodologies for sourcing income from the sale of manufactured inventory, in part, to place of manufacture and, in part, to place of sale. However, the Proposed Regulations under Section 865 treat Section 865(e)(2) as, in effect, overriding the statutory change to Section 863(b) for sales attributable to a US office, reinstating two of the three historic methods for dividing the source of the sales income based on place of manufacture and place of sale.
The Proposed Regulations were published in the Federal Register on December 30, 2019. When finalized, the Proposed Regulations would apply to tax years beginning after that date. Treasury and the IRS state that taxpayers may rely on the Proposed Regulations for tax years beginning after December 31, 2017, and ending before December 23, 2019, so long as they apply them in their entirety. The Preamble to the Proposed Regulations puts taxpayers on notice that the government may challenge positions taken by taxpayers for tax years before the regulations are effective.
The Proposed Regulations provide important guidance for taxpayers with cross-border supply chains, particularly those that manufacture inventory outside the United States for sale into the United States. The proposed rules for sales attributable to a US office seek to harmonize seemingly conflicting statutory rules, and can create unintended consequences unless analyzed in detail under each taxpayer’s particular facts.